The Shocking Secret Behind China’s Economy

Last week the Chinese stock market, represented by the Shanghai Composite Index, jumped a massive 4.3% in one day on heavy volume, as investor sentiment soared on the belief that the Chinese economy is beginning to recover. (Source: “China Stocks Jump Most Since 2009 on Support Speculation,” Bloomberg, December 14, 2012.)

There were also indications that the government is going to allow more institutions to purchase equities outright. This followed a better-than-expected Purchasing Managers’ Index (PMI), developed by Markit Group Limited, of 50.9, compared to November’s reading of 50.5. (Source: “China Stocks Jump Most Since 2009 on Support Speculation,” Bloomberg, December 14, 2012.)

Investor sentiment is trying hard to pick up signs that perhaps the Chinese economy is entering a recovery stage. While it is possible that the Chinese stock market has become oversold, there are still large structural issues for the Chinese economy to address.

I think one of the most serious problems for the Chinese economy that perhaps investor sentiment is not fully realizing is the shocking extent of debt levels within that nation.

According to estimates by a Chinese economic consultancy GK Dragonomics, corporate debt in China has risen from 108% of the entire economy in 2011 to 122% in 2012. (Source: “Corporate China’s Black Hole of Debt,” Bloomberg BusinessWeek, November 19, 2012, last accessed December 15, 2012.)

The problem is greater than just a few companies within the Chinese economy having large debt. GK Dragonomics calculates that when combining public, household, and corporate debt, the total amount is approximately 206% of gross domestic product (GDP). (Source: “Corporate China’s Black Hole of Debt,” Bloomberg BusinessWeek, November 19, 2012, last accessed December 15, 2012.)

That is a surprisingly high level of debt. Not only is the percentage level exceedingly large, but the Chinese economy is extremely intertwined with state-owned firms. Because the goal of China’s leaders for the Chinese economy is political stability rather than logical business-making decisions, there are plenty of situations in which overcapacity is becoming a problem.

As an example, steelmaking is currently in a state of overcapacity by approximately 200 million tons. But because the government does not want to close these businesses or fire the people, as that would create political instability, the economy becomes more fragile, built upon a house of cards.

This is becoming evident with the level of inability by companies to pay their bills. At the end of September 30, 2012, Chinese industrial firms had total accounts receivable of US$1.3 trillion, for goods already delivered. This is an increase of almost 17% from last year, a staggering number.

It appears as though to sell a product in the Chinese economy, a business must lend credit, and then hope to get paid at some point. With the massive rising of outstanding bills, this means that fewer businesses in the Chinese economy have the cash to pay for their goods.

While the U.S. government is having difficulty balancing its books, U.S. corporations, on the other hand, are in exceedingly strong shape. In comparison, firms within the Chinese economy are extremely fragile and are heavily reliant on the government for complete support.

Investor sentiment should be aware of how dangerous this type of situation can be for the Chinese economy. No nation can run its country in such a manner forever. While the Chinese economy might rebound over the short term, unless growth picks up worldwide to a level that’s substantial enough to absorb some of this overcapacity, we will see more firms in trouble in China, unable to pay their bills, creating instability.
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